Gift lift

Can you explain to the cautious investor what discounted gift schemes entail?

They are generally well accepted but a number of more cautious clients have expressed concerns when we explained one of the potential problems with these arrangements, in that the income cannot be reduced, deferred or suspended during periods of poor investment returns.

First, to recap on discounted gift schemes. The settlor determines the amount of capital they can irrevocably afford to gift to the trust, and the amount of income they want to draw. Typically, this is anything up to 5 per cent. A discounted gift trust is drawn up and the gift made to the trustees. The gift is then (usually) invested into a life insurance bond and, using the 5 per cent rule, the bond pays the income out to the settlor.

Depending upon the age and health of the settlor, a proportion of the gift is set aside in a reserve fund to meet the income payments. Subject to acceptance by HM Revenue & Customs in the event of the settlor’s death, this fund falls out of the settlor’s estate immediately. The balance of the fund is treated as a potentially exempt transfer, falling out of the estate over the following seven years.

The discounted gift trust is ideal for clients who have an inheritance tax liability, have spare and readily realisable capital, need a continuing tax efficient income, can afford to give up any access to the capital and who want to maximise the amount of their estate that passes free of inheritance tax to their beneficiaries.

But there are clear risks to this arrangement. If the income being taken, plus scheme charges, exceeds the underlying investment returns either by a large margin infrequently (particularly in the early years) or a small amount consistently, the capital value of the reserve fund being used to meet the income withdrawals can be eroded. Steady erosion of capital will, of course, exhaust the fund, leading to cessation of income and little or nothing to pass down to the beneficiaries.

The trustees have to balance the competing and often contradictory requirements of the two groups of beneficiaries – a sustainable income for the settlor, and capital security and wherever possible capital appreciation for the ultimate beneficiaries.

Given that the natural market for this type of arrangement is the elderly wealthy, many of whom are either cautious investors or completely risk-averse, these risks can be a very effective deterrent.

Until recently, we have striven to counter these risks by careful portfolio construction, using cautious, low-volatility, income-oriented investments, with the potential for some capital appreciation. But, as with any investment, neither the income nor the capital is guaranteed and the risks can only be reduced, not removed entirely.

A US company, The Hartford, has now entered the UK market with a very powerful proposition for the discounted gift trust sector. Little known in the UK until recently, The Hartford is a major financial institution, and is one of the biggest unit-linked investment bond providers in the world. Its proposition is an onshore UK life insurance unit-linked bond, offering investors access to a range of four fund of fund Gold portfolios – income, rising income, cautious managed and growth – and seven other fund. The range is not large but should meet the needs of most investors. The company offers three (draft) trust versions – flexible trust, loan trust and a discounted gift trust.

However, the most relevant factor is the safety net feature. This has two features which are directly relevant to discounted gift trust users. First, the safety net guarantees a full return of the policyholder’s total investment – over time as income, not as a lump sum – regardless of market performance. The policyholder is guaranteed to be able to take withdrawals of up to at least 5 per cent each year of the amount invested until they have received back the total amount invested.

The other aspect of safety net ensures that, on the death of the policyholder/ settlor, the death benefit payable would be at least equivalent to the total amount invested, plus any annual increases to the safety net value, less the withdrawals taken.

On each bond anniversary, depending upon under- lying investment returns, the guaranteed death benefit has the potential to be increased by up to 10 per cent.

The arrangement is not without cost – safety net is an optional insurance and adds 0.5 per cent to the annual management charge. That said, the total proposition, which includes a medically underwritten discounted gift trust, access to a carefully structured range of fund of fund portfolios and supported by a 20-year guaranteed income stream (assuming 5 per cent of original investment as annual withdrawals) and some capital security for the final beneficiaries makes for a powerful tool for cautious, elderly, wealthy and income-dependent clients.

The only disappointment from our point of view is that despite Hartford Life, the issuing company, being authorised by the Irish Financial Services Authority as well as being regulated by the FSA, its bond proposition is only available as an onshore arrangement.

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